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The strategic risks of U.S. debt and how to avoid them

U.S. federal government finances are on an unsustainable path — that is the unmistakable message from the Simpson-Bowles deficit reduction commission and emphasized by Defense Secretary Robert Gates. Both sources rightly stress the importance of bringing control to runaway deficits and the impacts on defense, but there is a larger issue at stake. The parlous state of the nation’s finances contains national security risks. The unsustainable path of U.S. sovereign obligations creates risk from foreign holdings of U.S. debt, a competition for resources at the federal level between security requirements and other priorities, and the potential for damage to the nation’s productive capacity. The untenable fiscal path also risks a compromise of the nation’s ability to respond to future uncertainty.

The long-term strategic problem of the nation’s finances is twofold. First, year-to-year U.S. finances are locked into a pattern of inflexible spending and massive borrowing. The federal government has in the space of a decade gone from modest surplus (2.4 percent of the gross domestic product) to significant deficit (10.5 percent of GDP). Spending has ballooned from 18.2 percent of GDP in 2000 to 25.4 percent in 2010, while receipts have dropped from 20.6 percent to 14.8 percent of GDP during the same period. Federal spending is already unsustainably high, given the present level of revenues flowing into the treasury. In the current political climate, the popularity of entitlements and the necessity to maintain interest payments virtually guarantee that these categories of spending will increasingly dominate the federal budget and leave few resources available for other government functions, including national security. Medical programs and Social Security (mandatory spending) and interest expenses require 60 percent of federal revenues. Absent change, these expenses will consume all federal receipts by 2025. In particular, rapidly accelerating costs of treatment will stretch the resources of government medical programs, and by extension, the overall federal budget. With defense the majority share of nonmandatory spending, Gates observes that “the Pentagon cannot presume to exempt itself from the scrutiny and pressure faced by the rest of our government.”

Second, and the more serious security concern, is the accumulation of deficits over time, which results in an unsustainable path for the nation’s debt. National debt imposes a burden on the economy best expressed as the ratio of debt to GDP. Deficits of a proportion to GDP greater than the U.S. nominal growth rate increase the nation’s debt burden at an accelerating rate. Growth in this burden left unchecked over time will lead to crisis.

Federal debt held by the public increased from 40 percent of GDP at middecade to more than 60 percent by the end of 2010. Total federal debt, which includes obligations to various trust funds, such as Social Security and Medicare, stands at more than 90 percent of GDP. Large and persistent budget deficits, projected at 6 percent of GDP indefinitely, will in the future increase this debt burden to levels unseen since World War II. At some point, capital markets will doubt U.S. ability to service its debt and demand higher interest rates as a compensation for the increased risk of default. The nation will find the strategic enabler of its borrowing capacity compromised as interest expenses spiral out of control. Budgets on autopilot from mandatory spending and a decreased borrowing capacity represent a reduction of “fiscal space” available for the nation to devote to strategic priorities.

THE RISKS

The path of federal finances poses several significant national security risks. First, the nation’s public debt stock is increasingly foreign held and the U.S. relies more heavily on international capital markets than ever to meet its public and private borrowing requirements. Though foreign holdings are relatively diffuse, large chunks of government and agency debt are held by nations that do not share U.S. security priorities. China’s central bank and government entities hold 22 percent of U.S. public debt — some $907 billion. Hong Kong, affiliated with the Chinese government, holds a further $140 billion of U.S. debt. Hasty sales of these massive holdings would do considerable damage to Chinese government finances. However, the risk remains that a foreign government would choose to subordinate economic priorities and use its holdings as a lever if its security aims clashed with U.S. interests.

More threatening than the actions of a single sovereign government is the risk that the bond market as a whole will turn against U.S. sovereign debt, perhaps in response to a loss of confidence on the part of a single large bond holder. Investors could flee from U.S. sovereign debt and cause a rise in interest rates, a change that would crimp federal finances and damage the recovering U.S. economy.

World capital markets have become more open since the end of the Cold War and the spread of Western-style capitalism. U.S. government borrowing since that time has drawn more from international sources as U.S. savings rates have declined. This development is a double-edged sword for American prosperity. Greater U.S. government involvement with foreign lenders affords access to a larger capital pool with low rates, but brings with it the discipline of world capital markets. The U.S. dollar is in high demand as the dominant world reserve currency and de facto source of international liquidity. The unprecedented demand for dollar-denominated debt affords the U.S. a borrowing capacity that can buy time for the nation to reform its fiscal stance.

However, this resource is not unlimited. In March, Moody’s sovereign debt monitor issued a note of concern regarding U.S. finances and suggested that the U.S. “Triple-A” credit rating could be at risk absent an improvement in U.S. finances. The short-term horizon of its bond portfolio suggests that the U.S. will place significant demands on international lenders at a time when Europe is seeking to finance its budget deficits. Faster growth rates in the developing world will likewise place demands on the world savings pool. U.S. borrowing capacity is vast and unique, but has its limits.

Where might the limit for U.S. borrowing lie? At its root, the answer is unknown as it depends on market sentiment, which can change quickly and without notice. The International Monetary Fund suggested that an upper limit of 160 percent of GDP for all debt — public and intragovernment holdings — is feasible, but this is an estimate highly dependent on assumptions. Given Congressional Budget Office projections of present law, the U.S. will reach such a debt level by the mid 2020s. The recently passed extension of 2001 and 2003 tax reductions moves this point forward by approximately two years. The precise moment of crisis is unknown, but the Moody’s and IMF estimates establish a range of sorts. The U.S. is clearly entering a dangerous space and runs the risk of a debt crisis within a decade absent change.

Second, diminished fiscal space places at risk the provision of security resources. The growing dominance of mandatory spending and increasing costs of debt service intensify the competition for federal resources out of which to fund security priorities. America’s aversion to increased taxes exacerbates this trend. Federal revenues from all sources have remained in a relatively tight post-1970 range of 18 percent to 21 percent of GDP, while federal government spending has maintained a 21 percent to 24 percent GDP range. Health care costs represent the fastest-growing portion of U.S. mandatory federal spending, are the single largest driver of future deficits and hold the key to the coming explosion of debt. Therefore, the federal government’s efforts to control health care costs are of great importance to the maintenance of its fiscal space.

The resource trajectories for mandatory spending and national security are on divergent trajectories. From 2000 to 2010, health care spending grew from 3.5 percent to 5.7 percent of GDP. Health spending will increase sharply in the next decade as costs of treatment rise and the retirement in force of the baby boom generation places increased demands on health insurance programs. By comparison, defense spending during the same period grew from 3 percent to 4.9 percent of GDP. Federal government budget projections assume defense spending will return to its post-Cold War level of 3 percent GDP once the operations in Iraq and Afghanistan conclude. Other elements of the U.S. security architecture have seen budget increases in the post-9/11 era, but future funding levels are uncertain.

Interest payments on the nation’s debt stock, while not mandatory, are essential to sustain if the U.S. wishes to continue its favorable access to capital markets. Gross interest charges are projected to surpass the Defense Department budget by 2018. This crossover occurs sooner if interest rates rise from present historic lows, as is likely given the recovery of world growth rates and increasing demands on the world savings pool. Absent meaningful and sustained revenue increases or adjustments to mandatory spending, national security priorities will compete within an ever-reducing pool of discretionary spending.

The most serious damage from intensified resource competition will likely occur in those niche capabilities generated from the smaller budgets of non-DoD agencies. This is not to minimize well-publicized DoD budget concerns. The defense budget suffers from its own internal tyranny of “mandatory” spending as cost overruns from existing programs, personnel costs and health care spending consume an ever-greater share of declining DoD resources. Cold War-era systems that make up the bulk of a still-formidable defense capability have been depleted rapidly and require costly refurbishment or replacement by systems more suited to current threats.

The federal budget process itself intensifies the competition for resources. The smaller budgets of agencies such as the State Department, National Security Agency, CIA and others provide critical capabilities and receive funding in combined packages that compete with other “discretionary” portions of the government. Defense receives its funds through a separate authorization. Such an arrangement and the demands of Americans for the services of their discretionary government create an environment ill-suited to adjudicate strategic risks created by resource reductions. Moreover, such an arrangement will make worse the dominance of defense within the overall security architecture.

Third, borrowing to support government spending competes with industry for resources in private capital markets. The U.S. government has the highest possible credit rating and potential to draw revenues from a $14 trillion economy. Recent U.S. Treasury auctions, though unprecedented in size, have drawn more than two buyers for each bond available. Such factors create a condition in which domestic industry effectively raises its capital after the U.S. government has met its financing needs. Federal government dominance in the capital markets gives it a vast potential to divert resources and substitute public for private spending. To the extent that this “crowding out” denies industry the resources necessary to conduct research and development, modernize its productive capacity and improve the human capital of its work force, future growth suffers. As borrowing absorbs a greater share of available savings, upward pressure on interest rates will grow. Such pressure puts the Federal Reserve in a difficult position — it can allow interest rates to rise and damage a fragile economic recovery or try to hold rates down with other ventures into the great unknown of quantitative easing.

The risk to growth is lower during recessions — when savings and productive capacity are idle — but rises as recovery employs capacity. U.S. security relies heavily on a vibrant private sector to provide the products and innovations necessary for dominance across a range of capabilities. Particularly vulnerable are the second tier and lower components of the defense supply chain, which are far less competitive in capital markets than the larger defense primes.

Perhaps the most underappreciated effect of diminished fiscal space is a reduced capacity for response to future unknowns. The extension of federal government resources to underwrite risk in wider areas of the U.S. economy signals the possibility for greater commitments in the future and further limits response capacity. The magnitude of resources and associated contingent liabilities committed to stabilize the financial sector and avert a larger downturn dwarf the size of the nation’s 2010 defense spending of $664 billion. Whether such interventions are an appropriate use of federal resources will be a subject of debate for some time. However, the precedent signals a broader role for the federal government in private markets and an interpretation of national security that transcends physical threats to the U.S. In the present fiscal stance, federal budgets bound by mandatory spending and saddled with onerous debt service lack the flexibility to reprogram resources on a massive scale in response to a changed security landscape. The appearance of a new peer competitor, natural disasters resulting from unexpected climate change, or renewed financial crisis among state and local governments would represent significant challenges for the U.S. government.

SOLUTIONS

Enough bad news — the good news is that the solutions are known. The nation’s fiscal condition, even its mandatory aspect, is set by policy. Policy is at the end of the day mutable. The many proposals generated in response to Simpson-Bowles provide a useful range of options for Americans to decide the size of government they wish to have, its strategic commitments and the resources necessary to fund them.

As a general guideline, deficits reduced to 3 percent of GDP will prevent a growth of the U.S. debt burden. More precise targets depend on a number of factors, the articulation of which is beyond the scope of this article. A reduction in the debt burden would require smaller deficits or U.S. real annual growth rates greater than their 2.5 percent historic norm. Therefore, most policy proposals call for an intermediate (five to 10 years) deficit target of 3 percent GDP as a prudent first step.

A significant portion of deficit reduction will occur in the course of recovery, a key element of any long-term plan. Most federal tax revenues derive from employment and business activity, both of which dropped sharply in the 2008 recession. As the U.S. recovers, increased tax revenues and reduced unemployment expenses will shrink the budget gap to 6 percent of GDP. But this recovery will be slow. Recent research by two leading economists indicates that recovery from financial crises of the 2008 variety will endure until middecade or longer. Austerity too suddenly enacted risks killing off any forming growth.

Simply stated, it is in U.S. and global interests for the United States to encourage its own short-term recovery as it enacts mid- to long-term fiscal austerity. Yet, deficit reduction that waits too long risks onset of a debt crisis. This and subsequent administrations face a delicate balancing of short-term recovery against long-term crisis.

The remaining path to a sustainable level — 3 percent of GDP — or complete deficit elimination — 6 percent of GDP — will involve a mixture of revenue increases and spending reductions across the federal budget. Revenue increases take the form of new taxes, increases to existing tax rates or elimination of selected exemptions from the tax code. Spending reductions in the mandatory category involve changes to benefit payments or altered eligibility requirements. The most important spending reductions will include control of rising health care costs. The aforementioned popularity of entitlement programs will render changes to mandatory spending difficult.

Adjustment is far more likely to occur in the 20 percent of federal outlays that constitute discretionary spending. In this regard, DoD and its partner national security agencies are perceived as both a cause of and solution for deficit spending. Both views are flawed. DoD spending increases since 2001 represent less than one-fifth of the fiscal reverse from 2.4 percent GDP surplus to 10.4 percent GDP deficit. Likewise, elimination of the entire defense budget would not close the federal deficit.

All groups that have studied the U.S. fiscal stance have included defense reductions. Requirements for defense and other areas of the national security structure must continue to be determined by strategy and associated threats from strategic requirements. The responsibility of national security professionals remains to ensure that strategy informs decisions and unbiased resource estimates. Likewise, they must articulate the risks and tradeoffs posed by budget constraints. Strategic planners should recognize that many U.S. security partners are largely in worse fiscal shape than the U.S. In most cases, Western partner nations have enacted more stringent fiscal reforms, all of which include defense reductions. Coalition solutions of the future will come with less partner capacity, which will require more from U.S. capabilities. But allocation is at the end of the day a political matter and could force a re-evaluation of strategic requirements. As one prominent writer has observed, strategy will proceed in an environment of reduced resources. Strategic planners should enter the next few years with “eyes wide open” in the matter of resource constraints.

The magnitude of adjustment required to achieve deficit targets, the size of the defense budget and experience all indicate that reductions are highly likely. How large might the DoD adjustment be? A return to the pre-2000 level of 3 percent from today’s 4.9 percent of GDP on conclusion of the conflicts in Iraq and Afghanistan and assumed in future budget projections implies DoD budget reductions of 40 percent from present levels. Even the 4 percent of GDP level favored by some parties would represent a one-fifth reduction from present budget levels. History indicates that adjustments stretch as long as a decade and involve difficult policy choices. Consequently, the more DoD can find its own savings, the more it will retain flexibility to fund priority programs

The alternative to a self-imposed path to fiscal sustainability is an environment of external constraint that removes all strategic flexibility. The U.S. must act now to address its long-term fiscal condition before world capital markets impose a discipline that will surely involve limitations unacceptable to Americans and inconsistent with U.S. security priorities. The U.S. is unique in the time it has available to restructure and balance short-term recovery with long-term debt risk. However, the U.S. is not exempt from the discipline of markets and can also suffer crisis. The risks of leverage from debt, constrained resources available for security and risks to the U.S. industrial base, as well as a reduced capacity to respond to future uncertainty, are extant and troubling. National security demands reform before the U.S. loses its strategic flexibility. AFJ

COL. MARK TROUTMAN, a career Army armor/operations officer, is the deputy chair of the Economics Department, Industrial College of the Armed Forces at the National Defense University. The views expressed in this article are those of the author and do not reflect the official policy or position of the National Defense University, the Defense Department or the U.S. government.